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Funds map differing routes to mitigate interest-rate risk

Risks and advantages differ as duration proves to be the stellar performer 

As the world awaits interest rate rises with bated breath, duration has been the stellar performer over the year to date.

The IMA UK Gilt sector delivered 9.42 per cent in the year to 13 November, according to FE Analytics, driven by falling government bond yields that caught everyone by surprise.

However, the 2.21 per cent yield on 10-year gilts – it got as low as 1.96 per cent in mid-October – is likely to increase over the next few years.

Several funds have launched to offer a reasonable return from such an environment.

Two that launched in September are James Tomlins’ M&G Floating Rate Note High Yield and Christine Johnson and Bastian Wagner’s Old Mutual Monthly Income High Yield.

While sharing a similar goal of mitigating interest rate risk, the funds take different paths with different risks and advantages.

The Old Mutual fund consists of a core of high-yield corporate bonds with a smaller portfolio of 10-year gilt futures used to manage the duration of the fund.

The futures sold by the fund means it can bank the difference in value of gilts if they fall although it has to pay up if the value grows.

Co-manager Wagner says this allows him to focus on creditworthiness and fundamentals rather than the duration of the instruments.

Sometimes the fund will take a stance on duration by selling more futures to go negative and make money off falling bond prices.

It can also buy futures to boost the fund’s duration beyond the roughly 6.5-year duration of the high-yield portfolio, as it did during the duration rally of the past few months, says Wagner.

“The advantage of doing it this way is futures are very liquid and we can open and close positions very quickly.”

The fund manages duration between minus-3.5 and plus-9.5 years – the higher the duration, the greater the accompanying short gilt position has to be.

A floating rate note fund would be constrained by the size of the market, says Wagner.

There are just 115 issuers worldwide offering bonds with coupons linked to interest rates and the market is skewed toward Europe, which makes up 57.5 per cent. The UK accounts for 20.8 per cent of the market and the US 16.7 per cent. 

“That means you have to buy whatever comes to the market. You don’t have the chance to buy what you like, you buy what arrives,” says Wagner.

The fund can be hit by a sudden “risk-off” event that sends gilt yields plummeting and with them the price of the future contracts. However, those positions can be quickly closed out and even reversed, he says.

Tomlins says the advantage of using floating securities is they offer greater upside when rates go up. “The disadvantage is the FRN market is not a huge market, the way to solve that is to go through a derivative route.”

While that makes the fund slightly more complex, it makes more sense to widen the fund’s options, he says.

Some 3 per cent of the portfolio is held in standard bonds with fixed coupons. The fund trades the fixed interest for a floating interest rate using interest rate swap derivatives.

The fund also buys floating US Treasury notes and sells credit default swaps for US and European corporate issues to add credit yield without interest rate risk. That accounts for 15 per cent of the fund.

On selling gilt futures such as Old Mutual, Tomlins says: “Duration hedging increases the amount of counterparty risk and the fund will be pretty derivative intensive.”

He admits his fund also sports counterparty risk from both the derivatives it uses to engineer zero-duration high-yield income.

When interest rates start to rise, the moves in collateral – difference between the face value of the future and its current market price – that counterparties would have to put up on 10-year gilt futures would be hefty, he says.

“Big moves in rates will mean big changes in collateral, which can open you up to problems.”

Both funds have too short a track record to judge but with recent economic data pushing back expectations of interest rate hikes, it could give investors time to see how they progress.


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